Cumulative Prospect Theory and the Variance Premium
45 Pages Posted: 14 Feb 2015
Date Written: December 31, 2014
Cumulative Prospect Theory (CPT) can explain the variance premium puzzle. We solve a simple equilibrium model with CPT investors and find that probability weighting plays a key role in generating a substantial variance premium, while loss aversion captures the equity premium. Using GMM on a sample of U.S. equity and index-option returns between 1996 and 2010, our estimate of the probability distortion parameter implies that real-world investors in option markets distort probabilities significantly, but less so than subjects in lab experiments. We also show that the CPT model prices the cross-section of out-of-the-money index options well. In a dynamic setting, probability weighting and time-varying equity return volatility combine to match the observed time-series pattern of the variance premium.
Keywords: Cumulative prospect theory, distorted probabilities, loss aversion, variance risk premium
JEL Classification: C15, G11, G13
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